Literature review on integration of regulatory capital and liquidity instruments

March 2016

This working paper aims at reviewing the literature's assessment of recent reforms. It consists of "three essays" on capital, on liquidity and its interaction with capital and on other supervisory requirements. Although there are many studies on the effects of capital requirements, there are relatively few on the effects of liquidity requirements and other supervisory tools. In part, this is because capital requirements have been in place for a considerable time and over more than one business cycle, while liquidity requirements and other supervisory tools, such as buffers, macroprudential policies and stress tests, have only been implemented since the recent financial crisis.

The essay on capital reviews a large number of papers that assess the impact of higher capital requirements in terms of the costs and benefits to economic activity and welfare. The essay on liquidity and its interaction with capital identifies a number of potential channels through which liquidity requirements can affect bank behaviour, balance sheets and profitability. Finally, the essay on other supervisory requirements discusses (1) whether measures other than capital and liquidity requirements adequately complement these regulations in making the banking system more resilient; and (2) whether simpler regulatory rules may be more robust to extreme stress events than the ones in place and whether stress testing can enhance robustness.